On the Relation Between Expected Returns and Implied Cost of Capital
24 Pages Posted: 18 Apr 2008
Date Written: April 15, 2008
In this study, we examine the relation between implied cost of capital and expected returns under an assumption that expected returns are stochastic, a property supported by theory and empirical evidence. We demonstrate that implied cost of capital differs from expected return, on average, by a function encompassing volatilities of, as well as correlation between, expected returns and cash flows, growth in cash flows, and leverage. These results provide alternative explanations for findings from empirical studies employing implied cost of capital on the magnitude of the market risk premium; relations between cost of capital, growth, leverage, and idiosyncratic risks; predictability of future returns, and characteristics of the firm's information environment.
Keywords: expected return, implied cost of capital, discount rate
JEL Classification: G10, G12
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